Crypto renaissance – An introduction to initial coin offerings and the importance of blockchain technology

Throughout history, new technologies have come along that quite literally change everything. One of the earliest examples is the study of astronomy which, dovetailed with the practice of agriculture, made it possible for societies to establish themselves as sprawling civilizations and grow out of their nomadic hunting and gathering. A more modern example is the development of efficient forms of lighting – from candles, to kerosene, to electric lightbulbs – that dramatically increased the productivity of our waking hours. And there are certainly many other examples in between. However, most recently, the widespread use of smartphones – and the many apps that provide users with social media, endless sources of reference, the ability to transfer funds, navigation, and countless other functions – are one of the newest technologies that have changed the way we live. For better and for worse.

The future, though, holds the promise of yet another technological paradigm shift. And at the heart of it is an esoteric data structure that floats invisibly through the internet. It’s called “distributed ledger” technology, but is better known as a “blockchain.” And while many people have heard of one of this technology’s well-known applications – Bitcoin – few people understand how, or even why, blockchains exist.

As the name implies, a blockchain is a distributed computer-based ledger, which means that the data that comprises the ledger, itself, is duplicated and stored on several different computers that are connected through a network. The ledger records transactions between different participants, each of whom has their own “wallet,” which is actually the participant’s private encryption key. Every time there is a transaction between wallets, a “block” is created and appended to the end of the “chain” of transactions. The new blockchain becomes the updated ledger that is propagated throughout the network. Since all the information is shared, regularly updated, and distributed, the transaction data is transparent and easy to reconcile. And because each block is encrypted, it is virtually impossible to access without a private key, thereby protecting users’ security and privacy. Due to the nature of the encryption, the longer the chain gets, the more difficult it becomes to hack and the more secure it becomes. However, even long blockchains can typically fit on an ordinary computer. As an example, the current Bitcoin blockchain, which contains eight years’ worth of transactions, is only about 150 GB long, which easily fits onto the hard drive of a laptop.

In a way, blockchains have put idle computing power to work the same way Uber and Lyft have done with idle automotive capital.

The privacy and security offered by blockchain technology make it a natural platform for the transfer of funds. This function is derived from yet another, much older, paradigm-shifting technology: currency.

All societies are based on economics, and an economy is nothing more than people exchanging goods and services. Bartering is the basis of every economy, but once economies become complex enough, offering uncountably different kinds of goods and services, bartering becomes inefficient. What happens is that a single commodity will become widely used as a means of exchange. The commodity will be available, but scarce, and easy to appraise. The most commonly used commodities for this purpose throughout history have been precious metals. By denominating all goods and services in terms of one single commodity, instead of in terms of every other tradable product, the entire economy is more transparent and efficient.

It is well-known that today’s modern currencies, including the U.S. dollar, are no longer backed by a commodity. They are created ex nihilo by central banks, which are essentially government monopolies, and backed only by the faith and credit of the issuing country. It has not been unusual in history for this kind of money to suffer crippling losses of purchasing power. In fact, the fear of this happening has only increased since 2008 as all the world’s major central banks have radically increased the money supply. This fear has a role in the development of alternative global currencies, like bitcoin, that are not government-sponsored. But one can’t help but suspect that the explosion in the number of different blockchains being engineered, along with their respective ‘coins,’ has caused supply to exceed demand. Further, what are the incentives for the issuers and investors of the ICO’s funding these new blockchains (other than making a quick buck)? Are ICO’s little more than scams that skirt SEC regulations? Or do they represent a facet of a technological paradigm shift? First, it should be understood that although bitcoin, or any other blockchain-based “coin,” might seem like a currency, this is technically not the case. They are more accurately labeled “tokens.” Fundamentally, currencies and tokens are similar in that their value is derived from what they can be exchanged for. The main difference between the two is the breadth of their utility. Major currencies are legal tender for all economic transactions. Tokens, via online markets, are exchangeable for major currencies. And they can also be used to pay directly for the services offered by the blockchain project, such as data storage, in much the same way that a token at an arcade or a drink ticket at a charity event might be used. In such a case, the ICO “investor” becomes a “consumer.”

The ultimate hope of cryptocurrency holders and ICO investors is that, with time, this difference between currencies and tokens begins to disappear, and a token like bitcoin begins to look like a medium of exchange that is not monopolized by any government. It has the advantages of cash (privacy, efficiency, free from administrative controls and costs) and combines them with the reach of electronic bank transfers. And because bitcoin is not physically transported, it is also free from the regulations imposed on cash, as well as the risks of civil asset forfeiture.

The utility of cryptocurrencies will only broaden as major retailers begin to accept them the same way they would currencies. Already, bitcoin is accepted by Microsoft, Overstock.com, Expedia, Steam, Intuit, and Japanese e-commerce giant Rakutan. The Libertarian Party accepts bitcoin donations. And recently, PriceWaterhouseCoopers, because of the increasing value of their tech consulting business, have started accepting bitcoin as payment for services.

As this list expands, one can only imagine the desirability of tokens will increase. Further, as governments keep imposing stricter regulations against the free transfer of funds, and as central banks continue to abuse their monopolistic control over the money supply, the virtues of cryptocurrencies become even greater.

This is why ICO’s have become so popular.

An ICO is brought to market in a similar way to an IPO. In the case of an ICO, a pre-announcement is made on a site frequented by coin investors, such as Reddit or Cyber Fund.

Typically, the initial draft of a white paper is released. The white paper will describe the project, the use that the blockchain will be designed for, and the funding goal. Interest is then gauged and criticism is fielded. On the basis of this feedback, the white paper is modified. The offering is made based on the final draft and the initial quantity of tokens to be offered will be assigned a value. Fiat currency, such as dollars may be accepted, but more typically investments are made using one of the major cryptocurrencies already established, such as bitcoin or ethereum.

ICO’s have become a preferred source of funding, over IPO’s, for tech ventures for several reasons.

First, the cost structure of an ICO is much lower since it is basically unregulated. There are no investment banking fees or venture capital concessions. The administrative costs of filing and listing are much lower. And since an ICO does not require articles of incorporation, the project need not pay corporate taxes. Investors are also free to get into and out of their investments as the market permits, unlike with IPO’s that typically impose tie-up periods. These benefits, however, come with risks. ICO mania is currently at fever pitch. And since a fundamental understanding of encryption, blockchains, and wallets is beyond the grasp of the average layman, the environment has attracted the larcenous and the gullible. So, scams are a constant danger.

This risk is exemplified by the Tezos ICO which raised $200 million. The originators are now being sued by investors. The ICO was floated too early, so the blockchain miners did not have enough time to produce the “Tezzie” tokens that needed to be delivered to their investors, who have so far been waiting for months while watching the bitcoins they invested skyrocket in value, sticking them with an expensive opportunity cost.

To reduce these risks, the marketplace has made efforts to weed out bad deals. ICO Rating [ICORating.com] acts as a watchdog and appraiser of ICO’s, much like Standard & Poor’s and Moody’s do for bond offerings. And ethereum offers multi-signature wallets that act as escrow accounts where funds are kept until the funding goal of an ICO is met. If it falls short, investments are returned.

In addition to ethical risk, there is also government risk. It may be that under current regulations the sale of tokens to U.S. citizens is technically illegal. And in any case, the SEC has stated its intention to regulate the market by declaring that tokens may be considered securities, and therefore under its jurisdiction. More recently, China has officially banned ICO’s. And the U.K. has also announced a crackdown on bitcoin users. They intend to pass legislation that forces cryptocurrency markets and wallet custodians to disclose the identities of their customers and report suspicious activity.

Cryptocurrencies have not been around very long. Bitcoin, the biggest, has only been around since 2009. The second biggest, ethereum, had its ICO in 2014. The “Ethereum Project” raised $18 million, and the initial offering of coins was priced at $0.40. Their “smart contract” platform went live a year later, and now, they are worth around $430. More recently, in August of 2017, FileCoin, a decentralized data storage blockchain, raised an astounding $250 million. The tokens offered can be used to store data and users can actually earn a dividend by donating free hard drive storage space.

In all of 2017, 200 ICO’s have raised a total of over $3 billion.

The global supply of cryptocurrencies is still quite small compared to the world’s major currencies. Bitcoin [BTC] is worth (as of the end of 2017) a total of $164 billion. Ethereum [ETH] is worth $42 billion. Ripple [XRP] is worth $9 billion. And, LiteCoin [LTC], $5 billion.

Altogether, blockchain-based tokens, are worth a few hundred billion dollars, which pales in comparison to the many tens of trillions of dollars’ worth of central bank issued fiat money. Recently, Jamie Dimon, the CEO of JPMorgan Chase, called people who buy bitcoin “stupid.” His statement was made out of shortsightedness or fear. The former, if he did not fully understand how much market share his bank could potentially lose to the fiat currency alternative. The latter, if he did fully understand.

About 80 percent of all funds transfers are processed through banks. Another 15 percent are done by check. The remaining 5 percent represents the small share left to cash, credit card and debit card transactions. All of these transfers have risks and costs that are addressed by blockchain technology.

Governments and established players will try to slam the brakes on this phenomenon, but the genie has been let out of the bottle, and it is hard to imagine it can be put back in.

Furthermore, this technology can potentially affect many more areas of the economy other than just funds transfers. Any business that depends primarily on robust transfers and is burdened with high costs and heavy regulation is at risk of being replaced by a distributed ledger system. These segments include: gambling and gaming, title insurance, cloud services and legal services.

The reason why blockchains and their respective cryptocurrencies are here to stay is not because they are rising in value. Bitcoin can go to $50,000 or crash back down to $50, and still the technology that drives it will have a very useful function. And it is because of this functionality that it will endure, much like other paradigm-shifting technologies that we now cannot imagine living without.